A Warning About YieldMax and Other Covered Call ETFs
Underperformance with a side of a larger tax bill.
This article is not meant to be financial advice. This is purely for informative purposes only, and opinions expressed are just that, my own opinion.
Don’t chase yield. Ever.
There has been a popular trend recently of single-stock ETFs that sell covered calls against the stock and return this premium as a dividend, often weekly. Stocks like Tesla and Nvidia have their own variants, even Bitcoin has an “income” strategy attached to it.
There’s a simple problem with these things: they suck.
The YieldMax NVDA Option Income Strategy ETF (NVDY) and TSLA variant of this ETF (TSLY) both have over $1 billion in assets each, and yield somewhere over 100%. They’ve become a popular holding of dividend investors on Twitter, but it is unlikely many investors in this fund understand exactly what they are buying. Today I want to break down exactly what these funds aim to do, and then issue a warning.
Basically, these ETFs own the underlying security, such as NVDA or TSLA in this case, and they sell covered calls against these shares, generating income on their position. This caps the upside gain these ETFs can generate, but it guarantees income for the investor.
This isn’t a new idea, and many investors utilize covered call strategies in their portfolios. It is a good way to generate income if you aren’t worried about potentially losing the shares you are selling covered calls against. You are trading upside for a guaranteed return when you sell covered calls.
The following charts are the returns of the underlying stock compared to the returns of the ETFs. As you will see, in both cases the underlying outperforms on a total return basis, which is important to use here due to the massive payouts. In the case of Tesla, the 1-year outperformance of the ETF is stark.
Here’s the biggest problem with these ETFs: The tax burden.
In the United States (I can’t speak for other parts of the world), the income generated from options is taxed at your marginal income tax rate, not the more favorable long-term capital gains rates and dividend rates. That means instead of paying 0%, 15%, or 20% taxes on the dividends, you are paying potentially up to 37%. If you’re at the highest tax bracket, for simplicity, you are paying an extra $17 in taxes per $100 than you would with an ordinary dividend or capital gains. This can absolutely crush the return you receive in these stocks, and this is not reflected in the performance of these ETFs. This means that you’re already underperforming the underlying stock because you want income, and on top of that you have a much larger tax bill.
This problem can get even worse, believe it or not. Sometimes these funds do a return of capital (ROC) instead of a dividend, which instead of paying you a current dividend it reduces your cost basis in your investment, potentially increasing the capital gains tax you will have to pay in the future when you sell your shares. Not ideal.
I’m not saying don’t buy these ETFs, what I am saying is know what you’re buying. The tax issue with these ETFs could resolved in a tax-free account, but the issue of underperformance to the underlying stock still remains. These can be a good portfolio diversifier and income generating, but please understand what you’re buying and where it can go wrong.
If you want an income generating strategy like this with much less single-stock risk, JP Morgan offers the JEPI and JEPQ ETFs, which have become wildly popular among dividend and income investors. JEPI sells covered calls against the S&P 500, and JEPQ sells covered calls against the Nasdaq. Both are great options for income investors especially.
For more dividend and dividend growth seeking investors, some of my favorites are SCHD, VYM, and DGRO. These have a good history of a moderate yield (between 2-4%) and growing their dividends 5%+.
I expect these single-stock covered call ETFs to continue to explode in popularity, and even start paying more frequently dividends. In fact, there are filings from Defiance to list DAILY dividend ETFs. This seems unnecessary and overkill, but I’m sure there is someone out there who will absolutely love this.